Growth in China, Bubbles in the West

In The Man Who Shot Liberty Valance (1962), the newspaperman, understanding the truth about the killing of Valance, burns his notes stating: “This is the West, sir. When the legend becomes fact, print the legend.”

Well, China’s economy has suffered a similar fate in the West.

For months, the chatter over the mainland’s presumed “hard landing” has intensified in the West. To many observers, the question is no longer whether the “China bubble” will burst, but when it will occur.

As the legend has become a social fact, it is printed in the West – all puns intended.

But is there any substance to these doomsday scenarios?

Property markets: short-term pain, long-term wealth

The stories of gloom and doom have been around ever since the onset of the global crisis in 2008-9. At the time, James S. Chanos, the wealthy hedge fund investor, warned that China’s surging real estate sector looks like “Dubai times 1,000 — or worse.”

A new round of doomsday prophecies has been accelerating since summer 2011, when the Eurozone crisis escalated and Washington’s debt-ceiling debacle resulted in the downgrade of the U.S. sovereign credit-rating.

Now the argument is that Chinese economy is about to face a “hard landing” because of a bursting property bubble, disproportionate reliance on exports, and excess capacity caused by growth through investment.

Certainly, the recent decline in home prices is likely to continue under pressure from government policies, which, in turn, accounts for the negative growth of residential floor space. If housing construction will continue to decline, that will have a negative impact on economic growth.

But since the housing downturn is induced by policy, it can also be reversed by changes in policy, which is precisely what happened in China amidst the onset of global financial crisis.

Truth be told, if government policies in China had ignored the overheated property markets, there would have been real cause for concern.

As China is changing, property markets should embrace change as well. It is time for developers to move from high-margin, high-end real estate to low-margin, middle-class properties.

Besides, the secular picture is promising. China’s urbanization rate is now 50%; about the same as in the United States in late 1910s. Just like urbanization fueled America’s growth in the past, it has the potential to drive Chinese growth years into the future.

It’s the net exports

Naturally, exports are vital to China. When exports markets suffer, that hurts exporters as well. But the devil is in the details.

During the global crisis, many foreign observers and correspondents predicted the collapse of Chinese economy because exports accounted for 35% of GDP. With the negative demand shock from the West, export-led growth collapsed, and so would China – that was the conclusion they considered only logical.

Unfortunately, they ignored imports, which were 27% of GDP and growing faster in relative terms. Moreover, GDP is driven by net exports (exports minus imports), not just by exports. In fall 2008, net exports were 8% of GDP; and today about 4%.

Setting aside the reduction of inventory overhang, softening of the external demand is a reality. By the same token, weakening trade balance is likely to limit the RMB appreciation even if gradual gains will resume over time.

The difference between net exports in 2008 and today is significant, but not fatal, and a part of it can be compensated. Private domestic demand has been strong. And as long as fiscal policy will ease, it will boost aggregate demand.

True, other analysts have pointed out that China has had a weak start in 2012. Industrial output was barely half of the annual government target. Nonetheless, a 2-month slowdown does not translate to annualized plunge; it followed an exceptionally fast build-up of inventories and an exceptional drop in new orders. New orders have begun to rise as manufacturers need to increase production.

Instead of a hard landing, the Chinese economy seems to be on track for a soft landing as long as monetary easing proceeds.

Investment as a balancing act

Since the onset of reforms in China, investment in China has climbed from 30% to almost 50% of GDP, while consumption has declined from over 50% to about 35%.

Nonetheless, the expansion of retail sales suggests that current deceleration is modest. Factor in the sharp slowdown in inflation and the figures do not look that bad in real terms. Indeed, the slowdown is not exactly a surprise in Beijing; it had been budgeted as part of the broader plan to shift the growth model toward consumption.

In the long-term, consumption is vital to boost well-being and prosperity in China, but nationally it requires greater advances.

After China joined the World Trade Organization in 2001 and economic reforms spread from the prosperous coastal urban regions to inland and western provinces, investment has increased accordingly.

Investment remains critical to China’s growth because it supports national industrialization and urbanization, which support to the reduction of poverty and the expansion of the middle-class in the less prosperous cities and rural regions.

If China moves toward consumption-driven growth too late, the more prosperous cities will be hurt. If, however, the transition happens too early, the less wealthy regions may fall behind.

The right timing and transition from investment to consumption is a balancing act – but one that has to happen in the terms of Chinese welfare.

From taming inflation to stabilizing growth

In China, the adverse impact of the ongoing global crisis has been most detrimental with the local government debt. Amidst the global crisis in fall 2008, China introduced a huge $586 billion stimulus package, which was designed to upgrade and expand the nation’s infrastructure.

The injection of liquidity sparked great confidence domestically and allowed for sustained growth – but as was the case in the West, not all of it ended in productive uses.

Eventually, local government debt rose to $1.7 trillion by the close of 2010, accounting for about a fourth of China’s GDP. Now local governments seek funding for infrastructure projects, land sales revenue is decreasing, government financing is tight, and regulators are cleaning up old loans made to local government financing vehicles.

Nonetheless, as long as funding for key projects is ensured and applying the brakes is done in a way that will avoid systemic risks, the debt is manageable. With $3.2 trillion of foreign reserves, there is also room for maneuvering.

Moreover, China can continue to lower the banks’ reserve requirement ratios and cut policy rates. And while local government financing reform is likely to be gradual, it is expected to result in an increase of local government bond issuance.

Before the crisis, local governments and state-owned enterprises had few incentives to privatize. Now there is a pressing incentive to implement privatization measures. The State Council’s “New 36 Clauses” is a prudent but practical plan to push privatization in state-owned assets in monopoly sectors.

Time for privatizations

There are real economic challenges in China, but gloom and doom stories are a matter of faith rather than analysis.

Fiscal loosening has been initiated, and monetary easing is likely to follow as inflationary pressures ease.

If China’s growth prospects differ from the doomsday prophesies, why do the latter persist?

Both the Eurozone and the United States are amidst a year of important elections. At the same time, the two suffer from low growth and high unemployment, which habitually penalizes incumbents.